Leases: New financial reporting rules for business leases

Authored by: Phil Santarelli

The Financial Accounting Standards Board (FASB) has issued a new standard for the financial reporting of leases that has been ten years in the making. The new standard, known as Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), will change the financial reporting obligations of companies that engage in leasing for assets such as real estate, vehicles, and equipment. The new standard is intended to make it easier for users of financial statements to compare different companies, but it will also likely have a range of additional repercussions for the companies themselves.

With this article, Baker Tilly is beginning a series designed to provide you with a general overview of the changes to the standard and insight into the challenges of transitioning.

Impetus for the new standard

In the introduction to the new standard, the FASB reports that most companies don’t report their lease obligations on their balance sheets. Moreover, transactions often are structured to achieve off-balance-sheet treatment. In 2005, the US Securities and Exchange Commission (SEC) estimated that SEC registrant companies held approximately $1.25 trillion in off-balance-sheet lease obligations. The effect of this widespread practice, according to the FASB, is that users of financial statements have difficulty comparing companies that own their productive assets with those that lease their productive assets.

In response to this problem, the FASB entered a joint lease accounting project with the International Accounting Standards Board (IASB) in 2006. The joint project did not achieve full convergence as the boards couldn’t agree on how to report leases on the income statement. However, the standards are effectively converged with respect to balance sheet presentation. The FASB standard follows the issuance of the IASB standard (International Financial Reporting Standards 16), released in January, 2016.

Changes for lessees

Under present GAAP, companies that lease assets (lessees) report a lease based on whether the lease is classified as a capital lease or an operating lease. Capital leases (for example, a lease of equipment for nearly all of its useful life) are recognized as assets and liabilities on a lessee’s balance sheet, but operating leases (for example, a lease of office or retail space for 10 years) are not. Operating leases appear in financial statements only as a rent expense and as a disclosure item.

ASU 2016-02 retains the two-lease classification model, but most capital leases will now be termed “finance leases.” The ASU will require lessees to recognize all leases with terms of more than 12 months on their balance sheets, regardless of their classification. At initial recognition, the balance sheet impact of both finance and operating leases is the same: the lessee would recognize the present value of the future lease payments as a right-of-use asset with a corresponding lease liability in the same amount. The discount rate to be used is the rate implicit in the lease (or, if the implicit rate cannot be readily determined, the lessee’s incremental borrowing rate, or in the case of private companies the risk-free rate can also be utilized).

The subsequent income statement and cash flow recognition differ, however, and will continue to depend largely on the lease’s classification.

  • Finance leases: Lessees will amortize right-of-use assets separately from interest on the lease liability on the income statement. Their repayments of the principal portion of the lease liability will be classified within financing activities, and their payments of interest on the lease liability and variable lease payments within operating activities, in the statement of cash flows.
  • Operating leases: Lessees will recognize lease expenses in income from continuing operations, computed to allocate cost of the lease over the lease term, generally on a straight-line basis. All cash payments will be classified within operating activities in the statement of cash flows.

Lessees also will be required to make additional disclosures to help users of financial statements better understand the amount, timing, and uncertainty of cash flows related to leases. They must disclose qualitative and quantitative requirements, including information about variable lease payments and options to renew and terminate leases.

The effects of the changes for lessees will not be limited to financial reporting. Companies will need to train their employees on the proper application of the new standard, as well as explain its impact to financial statement users. Lessees also will need to establish supplemental processes, systems, and controls to gather the necessary lease information.

The inclusion of leases on balance sheets could change the intended use of certain financial ratios and other measurements upon which debt covenants or other contractual commitments are based. The accounting changes might also result in stiffer borrowing costs for lessees if their balance sheets look weaker with their operating leases included. Businesses might consider buying property they previously would have leased, because the balance sheet impact will be similar.

Changes for lessors

ASU 2016-02 will have a much less dramatic effect for companies that own leased assets (lessors). Lessors’ lease accounting will remain largely unchanged from current GAAP. For example, most operating leases will still be classified as such, and lessors should continue to recognize income for those leases on a generally straight-line basis over the lease term. But the new standard includes some “targeted improvements” designed to coordinate lessor accounting with both the lessee accounting model and the updated revenue recognition guidance the FASB published in 2014 (ASU No. 2014-09, Revenue from Contracts with Customers).

Treatment of hybrid contracts

Businesses may enter contracts that come with both lease and service contract components (for example, maintenance services or other activities that transfer a good or service to the customer). The new standard retains the requirement that companies separate the lease components from the non-lease components, but provides additional guidance on how to do so.

The consideration in the contract is allocated to the lease and non-lease components on a relative standalone basis (for lessees) or according to the allocation guidance in the revenue recognition standard (for lessors). Consideration attributable to non-lease components is not a lease payment and, therefore, is excluded from the measurement of lease assets or liabilities. Activities that do not transfer a good or service to the lessee, or amounts paid solely to reimburse the lessor’s costs, are not components in a contract and are not allocated any of the consideration.

If lessees do not wish to allocate consideration to lease and non-lease components, they are permitted to make an accounting policy election to not separate the components and account for the entire contract as a lease. However, while such election may ease the administrative burdens, doing so will increase the amount of recognized lease assets and liabilities.

Differences from the international standard

The FASB and the IASB reached the same conclusions in many areas, including requiring leases to be reported on the balance sheet, but significant differences remain.

For example, the lessee accounting model in IFRS 16 requires leases to be accounted for under the approach the ASU requires for finance leases. Consequently, leases classified as operating leases will be accounted for differently under GAAP than under IFRS, with a different effect on the income statement and the classification of cash flows.

Don’t delay preparations

The new standard is effective for public companies for interim and annual periods beginning after December 15, 2018. Nonpublic companies must comply for annual periods beginning after December 15, 2019, and for interim periods beginning a year later. The FASB is permitting early adoption.

ASU 2016-02 requires a modified retrospective transition, which requires application of the new guidance at the beginning of the earliest comparative period presented in the year of adoption. For companies that present one or two years of comparative financial information, that means the systems and processes required to report under the new standard need to be in place sooner than the actual effective dates.

The new standard also includes several optional “practical expedients.” In general, companies that elect to apply these practical expedients will effectively continue to account and classify those leases that begin before the applicable effective date in accordance with previous GAAP (i.e., for income statement purposes as operating or finance leases). However, for balance sheet presentation, lessees must recognize a right-of-use asset and a lease liability for all operating leases at each reporting date based on the present value of the remaining minimum rental payments that were tracked and disclosed under previous GAAP.

The effective dates might seem like they’re a long way off, but the new standard should prompt companies — especially those with many leases or with manual, decentralized processes — to launch their preparations now. The implementation steps necessary to ensure compliance may well require the outlay of extensive time and resources.

For more information on the changes to the leases standard, or to learn how Baker Tilly specialists can help, contact our team.